Inside the Latest Fed Minutes

The Federal Reserve minutes of its June 14 meeting, released Wednesday, are notable for a few reasons. The Fed hiked rates despite a spate of weaker data. It also formally announced a plan to start reducing the balance sheet by slowing reinvestments, though did not specify when this program would begin. While both of those moves were widely expected, the minutes give us a deeper look at how the central bank is thinking, which in turn should provide more insight into what comes next. Faith in the Phillips Curve? Recent inflation measures have come in a bit lower than expected, which according to the Fed's models, shouldn't be happening with unemployment at these low levels. Many Fed watchers have attributed this to (perhaps misplaced) faith in the so-called Phillips Curve. The Phillips Curve is the theoretical relationship between unemployment and inflation. What is supposed to happen is that as unemployment falls, inflation rises. Based on the minutes, though, it seems that faith is waning. Several participants expressed concern that progress toward the Committee's 2 percent longer-run inflation objective might have slowed and that the recent softness in inflation might persist. Such persistence might occur in part because upward pressure on inflation from resource utilization may be limited, as the relationship between these two variables appeared to be weaker than in previous decades. In context, the conversation seemed to be about various types of resource utilization, not just labor. But I read this section as indicating there was at least a debate about whether the Phillips Curve holds. Many commentators have observed that it is hard to find this Phillips effect in historical data, at least post 1960s or so. This might mean that there is no relationship. It could also be that the Phillips Curve reflects a non-causal effect. That is, it isn't that low unemployment causes higher inflation, but rather that the same things that sometimes lead to low unemployment might also cause inflation. For instance, it is definitely true that if consumers don't spend more nominal dollars, you can't logically get more inflation. How could the price of goods be bid up if consumers weren't spending more total dollars? It is also logical that consumers are more likely to be spending more nominal dollars if wages were going up. Wages are more likely to be going up in a period where unemployment is low. From this sequence, we can see where a Phillips-style relationship might emerge. But there are a lot of more likely statements in there. Nothing definitive. Anyway, you probably don't really care about my views on the Phillips Curve. It seems that the Fed is nervous about unemployment being this low and trending lower, even if it isn't sure the Phillips relationship will hold. That probably means the central bank remains on track to hike again later this year barring a further slowdown in inflation or a slowdown in job growth. But it may also mean that in the absence of a rebound in inflation, the Fed might pause in the beginning of 2018, looking for stronger inflation data. Soft data vs. hard data The Fed's optimism in the face of some weaker data isn't just about a theoretical economic relationship. So-called soft data (i.e., surveys) as opposed to hard data such as the number of new hires, has been very strong lately. Data points including the Institute for Supply Management (ISM) survey, the National Federation of Independent Business (NFIB) survey, the Job Openings and the Labor Turnover Survey (JOLTS), have all painted a very optimistic picture. Long-time readers of this author know I'm very skeptical of surveys and strongly prefer hard data. But I will concede that business-oriented surveys are more reliable than consumer-based ones. And at least a survey has a chance of giving you some forward-looking information. For example, the JOLTS report shows the number of total job openings. In theory this is a forward-looking measure of labor demand, whereas the actual number of net new jobs is by necessity, backward looking. In the minutes, the Staff report highlighted the ISM and JOLTS. The FOMC members themselves mentioned JOLTS as well as anecdotal evidence from their districts. In effect they are saying, sure the most recent data looks mediocre, but this softer data sure seems to suggest that's just a temporary blip. If actual production and hiring catch up with what is indicated in these surveys, the economy will accelerate materially. Again, the Fed is worried about falling behind the curve, and wants to move closer to neutral. QE Portfolio Unwind On the much-watched end of QE reinvestments, the minutes don't give us a definitive guide. Several participants thought the plan could start within a couple months which would suggest September or maybe even in August. But there wasn't enough consensus on this to allow them to formally announce the timing after the June meeting. That means several wasn't enough to truly decide. I'd bet on September with a rate hike in December. What does this mean looking forward? We should assume that the burden of proof is now on no action. Unless the data comes in bad enough for a pause, the Fed will have hiked one more time plus begun unwinding the QE portfolio by year-end. It will be hiking roughly once per quarter until the hard data either turns definitively stronger or weaker. That makes the next few jobs and inflation reports extremely important for pricing in what happens in 2018.

Inside the Latest Fed Minutes

It seems the central bank is nervous about unemployment being this low and trending lower.

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